Can You Defend Ethics Of Contingency Deals?

This may be an impossible question to answer, as someone intent on unethical or dishonest behavior cannot be totally controlled.

No readers responding to our queries suggested abolishing contingent agreements. Many said something similar to one respondent: "Critics need to understand that a small percentage of individuals with bad behavior should not cause an alteration of an effective customer-service-driven business based on trust. The culprit is not the contingent, it is dishonest people." Another said: "Don't blame the car, blame the drunk driver."

It was also noted that the current attention was sparked by Placement or Market Service Agreements from a few brokers who have a limited number of customers that generate huge premiums per account. Those agreements were used solely to gain bonus fees in excess of the standard commission structure of a few insurers.

These are not true contingency agreements, but have been incorrectly lumped in with contingent agreements by some commentators. These "placement or service" agreements give the brokerage the ability to directly control its income, and that income is contingent only in the sense that standard commissions are contingent based solely on sales volume. There is virtually no contingency such as profitability involved.

Specific solutions from respondents varied. A few suggested that educating the client and regulators as to the nature and purpose of a contingency agreement was the answer. A majority suggested that the existence of contingency agreements should be disclosed in some manner or form. A minority opposed disclosure.

A large percentage of those favoring disclosure suggested that disclosure was only appropriate for certain producers.

As to education, customers and regulators need to know that sales incentives are a normal and accepted practice in society. Outside of the insurance business, manufacturers offer volume price discounts to wholesale and retail establishments. Some wholesalers and retailers will pass these savings on to their customers.

Even not-for-profit organizations offer incentives. Public broadcasting offers such incentives directly to its viewing audience during fund-raising activities. Some not-for-profit organizations will give rewards to those who raise the most money for the group. There does not seem to be an outcry against these practices.

In insurance, direct incentives to insureds are generally illegal. Regulators usually require that each member of a class pay the same rate. Commissions cannot be rebated, although some reduction in regular commissions may be allowed on certain commercial risks.

No state allows significant "gifts" to those who buy insurance, such as would be available for a contribution to public broadcasting. (Imagine the uproar from regulators if an insurer, agency or brokerage offered a rebate in the manner of auto manufacturers or dealers!)

Therefore, the only sales incentive the insurance company may offer is to those who sell its products. To be an incentive, it must encourage additional sales. To be a contingency sales incentive, there must be target standards for the additional business.

A true contingency agreement will be, in significant part, profit-based. Profit will be primarily driven by losses. To the extent that a contingency agreement requires the producer to assist the client with loss prevention, loss reduction and alternative methods of loss financing, and to the extent these activities are applied to the entire customer base of the agency or brokerage, and to the extent the activities work, the contingency agreement benefits the client, insurer and agency or brokerage.

This type of information and comparison with other businesses needs to be communicated to regulators and customers. A Texas educator said: "The purpose of contingency commissions needs to be explained, emphasizing that it rewards successful front-line underwriting and risk control efforts of the agency or brokerage."

"Clients will also be rewarded in the long run with lower premiums," added a Kentucky agent. Given the legal restrictions on pricing within the insurance business, education is necessary so everyone understands that, as one agent put it: "It's a long-term reward for a professional job well done."

Education is one valid approach. Another approach is disclosure, or "adding transparency" to the transaction.

The former president of a national agent association said: "It makes sense to disclose that part of my compensation may be contingency-based." An insurance company president was stronger: "Full disclosure is the only answer. All compensation ultimately is paid by the insured anyway. Let them know how much they are paying the middleman so they can evaluate the services provided."

A New York educator was blunt: "Contingent agreements are unethical if not disclosed." A former risk manager basically agreed: "Disclose contingency arrangements so the customer has knowledge of what additional factors may be influencing the sales process."

A New York broker suggested a pre-printed statement on the insurance contracts issued, such as: "The agent or broker for this contract is paid a commission based on a percentage of the premium. Additional incentive compensation may be paid based on the results of all business the agent or broker does with this company."

The opposing view was best summarized by a Florida producer: "Disclosure does not solve the problem. There are too many ways a person bent on dishonesty can manipulate the client."

Another problem leading to a belief in non- disclosure was the uncertainty of a true contingency agreement. One producer asked: "How can I possibly disclose how much additional contingency income I will get on a sale when the results are based on a complicated formula, and those results will not be known until some time in the future?"

A third view combined mandatory disclosure for some with no- or optional disclosure by others, recognizing that agents and brokers are supposed to represent different parties in the insurance sale. Within this third group, there were also those who would require disclosure of contingency agreements by intermediaries who are charging a fee, with no- or optional disclosure for those who are only receiving a commission.

The agent-broker distinction was phrased: "You don't expect the clerk at Wal-Mart or the auto salesman or even the nurse providing you care at the hospital to disclose his or her total package of compensation, so why expect the agent representing the insurance company to make such a disclosure. However, you can reasonably expect those you hire to work for you to reveal any other compensation or rewards they would receive from the work done for you. Brokers clearly fall into that category."

The fee/commission distinction was varied. An association executive commented: "When a fee is charged the client, any other source of income for the producer should be disclosed, such as the potential for a contingent commission. The fee was negotiated with the expectation that it would be the full compensation for the work. In a no-fee situation, no disclosure is required as there is no expectation on the part of the client as to how much the producer will earn."

However, this executive added, "even these producers should be willing to reveal the existence of a contingency commission agreement, if asked. If the client really wants to know how much will be paid under that agreement, give them a copy of it and let them figure it out, as it is next to impossible for the producer to give an accurate answer."

A New York broker opined: "If the broker and the client agree to an exclusive arrangement excluding competitive bidding, the broker should disclose any other related income that can reasonably be expected."

An Illinois agent said he had no trouble revealing the commission level his firm would receive, if asked. However, he does not volunteer the information because "in 45 years in this business, I have only been asked twice how much I would be paid on a policy."

A Kentucky agent said that in 40 years in the industry, he has placed every piece of business for clients without knowledge of the commission level on that account. "If asked, I can find out and let them know. In the few occasions when that has happened, the client was always both pleased and surprised because they expected the commission level to be significantly greater."

In summary, true contingent commission contracts are ethical tools. Such contracts are generally hard to understand and explain. Volume-only contingent contracts offer the greatest potential for unethical use.

Use of contingent contracts as a part of a bid-rigging scheme is blatantly unethical, and most probably illegal as well. Any other use of such contracts that do not place the interests of the client before the interests of the agent or broker is considered unethical.

Peter R. Kensicki is a professor of insurance at Eastern Kentucky University in Richmond, Ky., as well as a member of the Ethics Committee of the CPCU Society in Malvern, Pa.

Sidebar:

Head: What Should You Do?

Convincing clients and regulators that contingent contracts are ethical tools requires:

Educating them as to what types of agreements are true contingency agreements and which are not.

Explaining the purpose and role of sales incentives in general and the unique aspects of sales incentives in the insurance business.

In some situations at least, disclosing the nature and existence of contingency agreements.

Flag: What's Next?

Head: A Question Of Ethics?

In examining the ethics of contingent commission agreements, it became evident that there were disagreements as to the most ethical way to compensate sales personnel in the insurance business. From the perspective of an insurance company marketing executive whether using the independent agent, exclusive agency or direct writing distribution system what do you believe are ethical sales incentive tools that will generate increased sales from your ultimate sales force?

Second, from the perspective of an insurance agency or brokerage owner, given that the client ultimately pays you for your work, what is the compensation method or methods that would least challenge an ethical producer?

Please forward your responses to Dr. Peter R. Kensicki at ethics@eku.edu or snail-mail him at Eastern Kentucky University, 107 Miller Hall, Richmond, Ky. 40475-3101. All responses will be kept confidential.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, February 11, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.